Finances & Money

How does the central bank action influence the currency?

Central banks

They are in control of a country’s monetary policy. The central bank members will determine the size & rate of growth of the money supply, flow of money into an economy, which in turn affects interest rates.

Why interest rates are set

Interest rates are set for; loans, mortgages, credit cards, bonds and savings. The reward to lend, cost to borrow, reward to save. The changes to rates set by the central bank can have an impact on everyday lives for all.

The reasons for changing interest rates

Rates are raised to bring down inflation, a central bank will want to maintain price stability and they would have a target associated to that. For example, the Bank of England’s mandated target for inflation is 2%. Interest rates being increased will also slow down growth in most cases.

A central bank would cut interest rates to try and create inflation within the market, people will be able to borrow more money, which will stimulate consumers to spend more. As a result, it will lead to growth within the economy and see inflation increase.

Quantitative easing

Quantitative easing is an unconventional method of monetary policy, which will involve purchasing government backed assets, usually bonds. This is done typically when interest rates are already low, this would be another way to try and stimulate growth and spending, by pumping money directly into the financial system.

Voting members

Each central bank will have voting members, these will be the ones that are voting for how the central bank should act when it comes to monetary policy. They will vote on interest rates and quantitative easing. It is important to be aware of who these voting members are, as when they speak from time to time, ahead of interest rate decisions, they can often provide clues or insights into their stance and how they may look to vote. This on occasions can have an impact on currencies.

Hawks and doves

In general, hawks are the members who tend to want tighter monetary policy to cool inflation and growth whilst doves tend to want looser monetary policy to support growth and inflation.

Typically, a hawk’s view would tend to strengthen a currency, due to the measures in which they seek. On the other side, with doves their view would typically have a negative effect on the strength of a currency.

How does central bank action influence the currency?

Interest rate increases tend to strengthen a respective currency, as to attracts more foreign investment due to the higher returns. Whereas, cutting interest rates would naturally see a currency weakening.

Quantitative easing and stimulus measures would tend to weaken the relating currency, as it attracts less foreign investment. A government or central bank would be buying their own bonds, this drives the price higher, which results in the yield being reduced, again making this less attractive for foreign investors, forcing them to turn elsewhere. The logic also that QE is in effect printing more money and diluting the respective currency, resulting in the value dropping.

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Susan Paige

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